Value.able: Hot coals

PORTFOLIO POINT: Delta SBD is weaker than its peer Mastermyne in many respects, but with an expansion in Queensland on the cards, things could change.

Spec.u.li.tis (noun) 1. Inflation of one’s speculative stock-picking abilities.

In my line of work, I meet many finance industry professionals who generously forward their speculative tips unsolicited. A couple of them – the professionals, not the tips – are very good and have regularly mentioned stocks that have risen substantially. They tell me that some of these stocks will continue to rise substantially and because their track record is reasonably good – I believe one has funded an exotic car habit through speculation – and their research more in-depth than I would ever consider conducting on such speculative ventures, given the small amount of money involved for me, I occasionally weaken and succumb to their 'trust me’ pleadings. Rarely does this end well for me, hence the small amounts of money involved and very infrequent ventures. I never expect to make anything from their high-risk speculative tips and I don’t view their current crop (NSE, COE, SEA, VMG and BTR, if you must know) any differently.

I do expect to do well building and maintaining a portfolio of extraordinary businesses bought at discounts to intrinsic value.

I cannot value a company that currently makes no money, so my own brand of speculation (if that is what it should be called) would still need a business. That business needs to be generating a profit too and it needs to produce a reasonable return on equity, while trading at a discount to intrinsic value. This is as speculative as it gets for me (and it doesn’t sound much like speculation at all).

On a hiding to nothing, a refresher on intrinsic value is appropriate.

I use a proprietary model for calculating intrinsic value. In essence, if I have a bank account with $10 million and that bank account earns an interest rate return of 20%, and I decided to auction off the bank account in the public market, I am reasonably certain I would be able to secure more for that account than the $10 million of equity in it. Further, if I have two such accounts and one account pays all the interest out each year and the other pays no interest out but retains it, and each continues to earn 20% per annum, the account that paid no interest out would be worth more. Provided I cannot achieve a 20% return elsewhere, the latter account’s ability to compound earnings at 20% ensures its higher value.

But imagine a bank account that had $10 million of equity and was earning, say 12%, retaining and compounding 65% of that return, and was available for $9 million. That’s right, a discount to equity. I think I have found just such a company. It’s not perfect, as there is debt and arguably unjustified goodwill on the balance sheet involved. It’s both too small (about $100,000 worth of trades per month on average) and too risky for The Montgomery [Private] Fund, but it ticks a few boxes to warrant some speculative exposure, given its price.

Delta SBD (ASX: DSB) is a peer to Mastermyne (MYE) – a company whose shares we do own, in very small quantity, through The Montgomery [Private] Fund and which I wrote about last week.

DSB’s mining contracting segment specialises in the provision of services for the underground coal mine industry, whole of mine operations, roadway development, longwall relocations and support, conveyor installations and maintenance, plant hire and maintenance, supplementary labour, and mine service. The latter includes secondary support installation, excavation, ventilation device installation and services/utility installation/recovery. If that doesn’t sound like Mastermyne, then this will: the company provides mining services in the Illawarra, Hunter Valley and the Western regions of NSW, and the Bowen Basin in Queensland. Further, like Mastermyne, limited 'through-the-cycle’ performance transparency means investors are right to be cautious about a company that is either new or newly-listed.

Not only do the two companies share geographic similarities, but they also share a similar client base. And these similarities do highlight an important risk – the relatively low barriers to replication and competition, which in turn are reflected in DSB’s lower returns on equity.

The other differences are price and operations. Mastermyne has almost three quarters of its contracts by number based in Queensland. It enjoys higher margins there. Delta SBD, on the other hand, has three-quarters of its contracts based in New South Wales. DSB is also more capital and labour-intensive than Mastermyne, reflecting its current capital expenditure programme. And the capital expenditure program has also caused divergent balance sheets. Mastermyne’s debt is falling and it generates positive free cash, while DSB has more debt and (currently) negative free cash flow.

You can see why Mastermyne is a small position in the Montgomery [Private] Fund and DSB is not. But as the company expands in Queensland, some of these price-limiting issues may abate. And that’s where any value could, with the low liquidity, quickly disappear just as the valuation starts rising.

For the first half of 2012, DSB reported revenue up 40% and a normalised net profit of $3.5 million, up 61.0% on the first half of 2011. Importantly, EBITDA margins improved compared to the previous corresponding period and the company announced a 1.5 cent dividend.

Like Mastermyne last week, you have to watch cash flow, because capital expenditure increases in anticipation of equipment demand for new contract wins, but the ramp-up in the number of staff, from 418 to 489, indicates optimism on this front. It also suggests that the small number of analysts covering the company could be too conservative in their estimation of earnings growth, given the company’s strong tender pipeline and generally rising tide in coal production. At the current price of 80 cents, the shares are trading at just seven times earnings and more importantly, at a discount to forecast 2012 equity, even though that equity generates a positive return of circa 12 per cent.

So there you have it – the first and last time you will hear about speculation from me.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.